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In its simplest form a letter of credit (“LC”) is a banks promise (known as an undertaking) to make payment to a seller for goods and/or services. The bank remains separate, autonomous, from the business contract between the buyer and seller, only guaranteeing payment on the production of documents that comply with the terms and conditions of the undertaking that the bank is required to perform. That the bank remains detached is referred to as the autonomy principle, and this coupled with the LC is pivotal to the success of international trade and the convenience of international commerce.

However, with the bank obliged to make payment, this does leave the bank open to potential fraud. There are several ways fraud could be committed, but the most prevalent appear to be the following:

  1. Bogus companies are set up by the fraudster, so he or she becomes both the buyer and the seller. The bank makes payment believing that they are paying the seller, when in reality they have paid the fraudster. The company is quickly shut down and the money moved before they can be traced.
  2. Forged compliant documents. The seller will provide false papers to the bank, who will then make payment based on the forged papers. The seller, also in this case the fraudster, then takes the money and also the goods involved in the transaction, leaving the buyer without goods and the bank defrauded.

The problem with the LC fraud, is the standards placed on banks in the detection of fraud. By this I mean that the fraud needs to be clear, almost obvious, it cannot be a mere suspicion. Case law has suggested that the proof of fraud needs to be higher than that which would leave a reasonable professional banker to infer that a fraud is being committed. This is because Courts are reluctant to interfere with the autonomy principle, as the danger is that this would hinder the purpose of the letter of credit and thus restrict the fluidity of international trade. In this respect, the bank can only ever stop payment if there is a prima facie case of fraud. The general rule is, is that if there is a suspicion of fraud, payment should be made and then the bank can pursue the fraudster.

However this puts banks in a very difficult position, and domestic law does little to help the plight of the bank. Whilst the United Customs and Practice for Documentary Credits 600 (UCP 600) is considered one of the most successful sets of rules to govern trade, it makes little reference to fraud. This means that it is often left to the domestic law of the country of the affected bank to decide how the matter should be dealt with. This leaves banks and the concept of the letter of credit open to abuse from fraudsters.

To safeguard themselves, the only thing that banks can really do is to perform their due diligence. They need to know their customers and who their customers are doing business with, to try and avoid fraud. Increased due diligence and ensuring the proper training of bank staff is best protection and prevention a bank can have.

If you have any questions regarding Fraud, meet with one of our expert consultants, Nasir Khan.